Lecture 4 Competitive equilibrium: government intervention Microeconomics 1000 Lecture 4 Competitive equilibrium: government intervention

Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchanged quantities. While at equilibrium each agent can trade whatever he or she wants, it may be true that not everyone is “satisfied.” 2 2

CONTROLS ON PRICES Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors. Price Ceiling A legal maximum on the price at which a good can be sold. Price Floor A legal minimum on the price at which a good can be sold. 3 3

How Price Ceilings Affect Market Outcomes Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above the equilibrium price. The price ceiling is binding if set below the equilibrium price, leading to a shortage. 5 5

Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Price Supply Demand 4 Price ceiling 3 100 Equilibrium price Quantity Equilibrium quantity

Figure 2 A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Price Supply Demand Equilibrium price 3 2 Price ceiling 75 125 Shortage Quantity Quantity supplied Quantity demanded Copyright©2003 Southwestern/Thomson Learning

How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates shortages because QD > QS. Example: Petrol shortage of the 1970s nonprice rationing Examples: Long queues, discrimination by sellers 11 14

Figure 3 The Market for Petrol with a Price Ceiling (a) The Price Ceiling on Petrol Is Not Binding Price of Petrol Demand Supply, S1 1. Initially, the price ceiling is not binding . . . Price ceiling P1 Q1 Quantity of Petrol Copyright©2003 Southwestern/Thomson Learning

Figure 4 The Market for Petrol with a Price Ceiling (b) The Price Ceiling on Petrol Is Binding Price of S2 Petrol 2. . . . but when supply falls . . . Demand S1 P2 QS QD Price ceiling 4. . . . resulting in a shortage. 3. . . . the price ceiling becomes binding . . . P1 Q1 Quantity of Petrol Copyright©2003 Southwestern/Thomson Learning

CASE STUDY: Zero price ceiling Some transactions are legal if the price for them is set at zero. This is equivalent to having a zero price ceiling Examples Organ donation

Figure 5 The Market for Organs with a Illegal Trade in Organs (Price Ceiling equal to Zero) Price of Kidneys S1 P1 Q1 Price ceiling Quantity of Kidneys Copyright©2003 Southwestern/Thomson Learning

CASE STUDY: Rent Control in the Short Run and Long Run Rent controls are ceilings placed on the rents that landlords may charge their tenants. The goal of rent control policy is to help the poor by making housing more affordable. One economist called rent control “the best way to destroy a city, other than bombing.” 2

Figure 6 Rent Control in the Short Run and in the Long Run (a) Rent Control in the Short Run (supply and demand are inelastic) Rental Price of Apartment Supply Demand Controlled rent Shortage Quantity of Apartments Copyright©2003 Southwestern/Thomson Learning

Figure 7 Rent Control in the Short Run and in the Long Run (b) Rent Control in the Long Run (supply and demand are elastic) Rental Price of Apartment Supply Demand Controlled rent Shortage Quantity of Apartments Copyright©2003 Southwestern/Thomson Learning

How Price Floors Affect Market Outcomes When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus. 12 15

Figure 8 A Market with a Price Floor (a) A Price Floor That Is Not Binding Price Supply Demand Equilibrium price $3 100 2 Price floor Quantity Equilibrium quantity Copyright©2003 Southwestern/Thomson Learning

Figure 9 A Market with a Price Floor (b) A Price Floor That Is Binding Price Supply Demand Surplus 4 Price floor 80 120 3 Equilibrium price Quantity Quantity demanded Quantity supplied Copyright©2003 Southwestern/Thomson Learning

How Price Floors Affect Market Outcomes A price floor prevents supply and demand from moving toward the equilibrium price and quantity. When the market price hits the floor, it can fall no further, and the market price equals the floor price. A binding price floor causes . . . a surplus because QS > QD. nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price supports 15 24

The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay. After developing the theory of labour demand and labour supply in Lectures 16 and 17 we shall analyse the problem of minimum wage in greater detail

TAXES Governments levy taxes to raise revenue for public projects. Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. The way the tax burden is divided between buyers and sellers is the main subject of the foregoing analysis 20 29

Elasticity and Tax Incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market. Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on. 21 31

Figure 10 A Tax on Consumption Price Price buyers pay Supply, S1 D1 D2 £3.30 90 Equilibrium without tax Tax (£0.50) Price without tax 3.00 100 A tax on consumption shifts the demand curve downward by the size of the tax (£0.50). 2.80 Equilibrium with tax Price sellers receive Quantity Copyright©2003 Southwestern/Thomson Learning

Figure 11 A Tax on Consumption (alternative viewpoint) Price Demand, D1 A tax on consumption shifts the supply curve upward by the amount of the tax (£0.50). Price buyers pay S2 Equilibrium with tax S1 £3.30 90 Tax (£0.50) Price without tax 3.00 100 Equilibrium without tax 2.80 Price sellers receive Quantity Copyright©2003 Southwestern/Thomson Learning

The gross price, pG, is the price paid by buyers Net and gross price With a tax in place, one has to distinguish between the net and gross price The gross price, pG, is the price paid by buyers The net price, pN is the price received by sellers With no tax, pG = pN (=p) With a tax t, pG = pN +t 21 31

Which curve shifts With a tax, pG ≠ pN so we must choose whether to plot on the vertical axis pG or pN Which curve shifts depends on this choice If we plot pN, then the demand curve shifts to the left If we plot pG, then the supply curve shifts to the right

Elasticity and Tax Incidence In what proportions is the burden of the tax divided? The answer depends on the elasticity of demand and the elasticity of supply. 29 39

Figure 14 How the Burden of a Tax Is Divided (a) Elastic Supply, Inelastic Demand Price 1. When supply is more elastic than demand . . . Demand Price buyers pay Tax 2. . . . the incidence of the tax falls more heavily on consumers . . . Supply Price without tax 3. . . . than on producers. Price sellers receive Quantity Copyright©2003 Southwestern/Thomson Learning

Figure 15 How the Burden of a Tax Is Divided (b) Inelastic Supply, Elastic Demand Price 1. When demand is more elastic than supply . . . Demand Price buyers pay Supply Tax 3. . . . than on consumers. Price without tax 2. . . . the incidence of the tax falls more heavily on producers . . . Price sellers receive Quantity Copyright©2003 Southwestern/Thomson Learning

ELASTICITY AND TAX INCIDENCE So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic. 30 41

Fiscal Revenue The revenue collected by the government is unit tax × (post-tax)quantity If quantity were constant, fiscal revenue would increases at a constant rate as the unit tax increases But one effect of increasing the tax is to decrease the quantity Thus, fiscal revenue will increases at a decreasing rate and may even decrease

Laffer curve Indeed, one can always imagine a unit tax large enough that quantity vanishes As a result, fiscal revenue must also vanish That means that as the tax increases, fiscal revenue must eventually decrease

Laffer curve fiscal revenue tax If the economy is on the decreasing part of the Laffer curve, a free lunch is available tax

Laffer curve However, when American President Ronald Reagan cut taxes following Arthur Laffer’s advice, the result was the biggest public defict in the history of the US (before the 2008-2009 crisis)

Summary Price controls include price ceilings and price floors. A price ceiling is a legal maximum on the price of a good or service. An example is rent control. A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage.

Summary Taxes are used to raise revenue for public purposes and for other purposes (such as internalising externalities or reducing consumption of demerit goods). When the government levies a tax on a good, the equilibrium quantity of the good falls. A tax on a good places a wedge between the price paid by buyers and the price received by sellers.

Summary The incidence of a tax refers to who bears the burden of a tax. The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. The incidence of the tax depends on the price elasticities of supply and demand. The burden tends to fall on the side of the market that is less elastic.